Assessing the Euro parity unlikely to the bottom

Date:

  • News by AUN News correspondent
  • Friday, July 15, 2022
  • AUN News – ISSN: 2949-8090

You have likely been monitoring the gradual decline of the euro against the US dollar and wondering when the slide may end. As an investor or business leader, understanding the factors impacting the euro and potential future scenarios is critical to strategic planning and risk management. While reaching parity with the dollar is a psychologically significant level, the fundamentals suggest the euro may weaken further. Macroeconomic pressures, political risks, and a weak growth outlook are headwinds facing the single currency.

This article will analyse the forces weighing on the euro, discuss key events on the horizon, and evaluate the likelihood of a near-term recovery. Although the currency markets are difficult to predict, the balance of probabilities suggests the euro’s troubles may not end at parity. Investors should consider the implications of a weaker euro and be prepared for a range of possible outcomes. With careful analysis and planning, businesses and investors can turn currency shifts from a threat into an opportunity.

Why the Euro May Weaken Further?

The euro’s recent slide to parity against the US dollar is unlikely to mark the nadir of its fall. Several factors suggest the single currency may weaken further:

  • First, the economic outlook for the Eurozone remains gloomy. The bloc faces slowing growth, high unemployment, and the threat of deflation. Gross domestic product expansion is forecast to be a mere 1% in 2019, inflation remains well below the European Central Bank’s 2% target, and the jobless rate stands at 8.2%, more than double that of the US. This lacklustre performance undermines the euro.
  • Second, the ECB’s hands remain tied. The central bank has little scope to lift interest rates from their historic lows to support the euro, as that could choke off the region’s fragile recovery. At the same time, an expansion of the ECB’s massive bond-buying programme, aimed at stimulating growth, would put further downward pressure on the single currency.
  • Third, the economic and political risks facing the Eurozone have mounted. Concerns over Italy’s debt levels, France’s economic reforms, and Brexit continue to trouble investors. Until these risks dissipate and stability returns, the euro will struggle to gain ground.

While the euro’s slide to parity with the dollar has been steep, the beleaguered single currency likely has further to fall given the region’s bleak economic outlook, limited policy options, and multiple political and economic risks. Investors should brace for the possibility of the euro testing new lows in the months ahead.

Interest Rates Remain Too low

The euro is unlikely to stabilise at parity with the US dollar. Interest rates in the Eurozone remain too low to provide adequate yield differentials that would attract global capital flows and strengthen the euro.

The European Central Bank (ECB) continues to employ negative interest rates and quantitative easing to stimulate growth in the Eurozone economy. While these measures may support economic activity, they reduce yields on euro-denominated assets and the appeal of the euro.

Short-term interest rates in the Eurozone remain negative at -0.5%, while rates in the US are positive at 2.25-2.5%.

The yield on 10-year German bunds, a proxy for the Eurozone, is -0.2%, while 10-year US Treasury yields are 2.6%.

The interest rate differential between the Eurozone and the US favours dollar-denominated assets, putting downward pressure on the euro. For the euro to stabilise, the ECB needs to normalise monetary policy by:

  • Raising interest rates to zero or slightly positive levels This would reduce the rate differential with the US and support the euro.
  • Reducing quantitative easing by tapering and ending asset purchases. This would shrink the ECB’s balance sheet and increase net demand for the euro.

However, inflation remains below the ECB’s target, limiting its ability to tighten policy. Fiscal stimulus may be needed to boost growth and inflation and enable the ECB to raise rates. Structural reforms are also necessary to improve competitiveness, support long-term growth, and strengthen the euro.

In summary, as long as a sizable interest rate differential with the US persists and inflation remains low, the euro is likely to remain under pressure. For the euro to stabilise at parity or higher levels, changes in ECB policy and Eurozone reforms will be required.

Quantitative Easing Has a Limited Effect

Limited Impact on Inflation and Growth

Quantitative easing (QE) by the European Central Bank (ECB) has had a limited effect on inflation and economic growth in the Eurozone. The ECB’s bond-buying programme was intended to increase the money supply and spur lending, investment, and consumer spending. However, the results have been marginal.

Core inflation remains stubbornly below the ECB’s target of close to 2%, indicating demand is still weak. While QE did lower borrowing costs for governments and some large corporations, lending to small and mid-sized enterprises has not increased substantially. Banks remain risk-averse, given uncertainties in the economy and financial markets.

QE also failed to significantly boost economic growth. The Eurozone continues to expand at a tepid pace of around 1–1.5% annually, with some countries still struggling to return to pre-crisis levels of output. Structural issues like high unemployment, large debts, and weak productivity continue to weigh on the economy.

Monetary policy alone cannot fix such deep-rooted problems. QE provided temporary relief but could not generate self-sustaining growth. Fiscal and economic reforms are also needed to complement the ECB’s actions and support long-term prosperity.

Overall, QE fell short of hopes and expectations. While it helped avoid worse outcomes like deflation, it lacks potency when interest rates are already low and private sector confidence is weak. Parity may not represent the bottom for the euro if the ECB’s toolkit remains limited and growth stays sluggish. A weaker currency is unlikely to drive inflation on its own without a broader economic turnaround.

The ECB should continue to monitor price stability and support growth. However, it must recognise the limitations of its policy and call on political leaders to do their part in strengthening the Eurozone. Monetary and fiscal authorities need to work together to overcome the remainder of the crisis and lift the region to its full economic potential.

Political Instability Impacts the Euro

Political instability and uncertainty frequently negatively impact currency valuations. The euro is no exception. Political events in the Eurozone and the larger EU have an impact on the euro because it is the common currency of 19 of the 27 European Union member states.

Brexit Impacts

The years-long process of the United Kingdom leaving the EU, known as Brexit, has weakened the euro. The drawn-out negotiations have led to uncertainty over trade relationships and economic ties between the UK and EU, putting downward pressure on the euro. While a trade deal has now been struck, its narrow scope leaves many questions unanswered about the future relationship.

Rise of Populist Parties

The rise of populist political parties and politicians within Eurozone countries poses risks to the euro. Leaders who favour more nationalist policies and oppose European integration may gain more influence. For example, Marine Le Pen’s far-right National Rally Party continues to gain support in France. If she wins the French presidency in 2022, she will likely push for policies that prioritise French interests over European cooperation, which could undermine the euro.

Disagreements Among Members

Disagreements among Eurozone members over issues like fiscal policy, immigration, and democratic values can damage confidence in the euro. For example, political disputes between Western European countries and Hungary and Poland over rule-of-law issues have strained relationships within the EU and highlighted some of the challenges of European integration. Such divides fuel speculation that the EU and Eurozone may struggle to remain unified over the long term.

While political events are challenging to predict, it is reasonable to assume there will be additional episodes of instability that pressure the euro. As a result, investors should not assume parity with the US dollar will be the floor for the euro, as further political ructions could drive it lower still. Close monitoring of European political developments is warranted to assess both the downside risks and any upside potential for the euro.

Where the Euro Could Be Headed?

Fundamental Weaknesses remain

While parity with the US dollar is a psychological barrier, the euro’s fundamental weaknesses have not disappeared. The European Central Bank (ECB) continues to struggle to stimulate growth and manage inflation across the 19 economies of the euro area. Structural reforms are still needed to boost productivity, reduce unemployment, and promote long-term sustainable growth.

Political Instability looms

Political uncertainty also poses risks to the euro. Anti-euro and populist parties are gaining traction, threatening the single currency’s future. The refugee crisis has exposed deep divisions among member states, intensifying Euroscepticism. If political instability intensifies or policymakers fail to implement critical reforms, confidence in the euro may falter.

Quantitative Easing Has limits

The ECB’s quantitative easing programme has helped stabilise the eurozone economy but has limits. Interest rates are already negative, and the ECB’s balance sheet has ballooned to over 4.5 trillion. While the ECB stands ready to do more if needed, monetary policy alone cannot solve the euro zone’s economic woes. Fiscal stimulus and structural reforms are also required but remain elusive.

  • Low inflation and growth: Inflation remains below target, and growth is uneven and lacklustre. Without reforms, the spectre of deflation and recession still looms.
  • Banking sector weaknesses: While banking regulations have tightened, some banks’ weak profitability and high non-performing loans pose financial stability risks.
  • External threats: The Eurozone remains exposed to external shocks like a slowdown in China, volatile oil prices, and trade tensions.

While euro/dollar parity is significant, the euro’s path depends on progress in strengthening the monetary union. For the euro to appreciate sustainably, political and economic reforms that boost growth, productivity, and confidence in the single currency union are critical. Without these, the euro’s troubles may not have bottomed out.

Conclusion

Many wonder if parity is at its bottom as the euro continues to slide against the dollar. Based on current economic fundamentals and the divergence in monetary policy between the Fed and ECB, parity seems unlikely to hold as a floor. The ECB is still easing while the Fed tightens, a dynamic that historically weakens the euro. Also, the economic outlook for the Eurozone remains uninspiring relative to the US, with lower growth and inflation expected.

Structural issues within the Eurozone also persist, including high debt levels in countries like Italy, political uncertainty, and a fragmented banking system. These long-term issues will continue to weigh on the euro. While temporary bounces are possible, the euro’s longer-term direction is still down. If the ECB does not change course, the euro could test its multi-decade lows against the dollar. For investors, the risks remain to the downside for the euro. The bottom may still be farther out than many expect.

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